Friday, April 18, 2014

This One Figure Shows Why Fed Policy Failed

Technically, it shows that the Fed's balance sheet is expected to shrink and return to the path it would have been on had there been no large scale asset purchases (LSAPs) over the past five years. This projection is a reflection of FOMC's plan to eventually normalize the size of the Fed's balance sheet. Bonds markets have understood this plan from the beginning as is evidenced in their inflation forecasts. The FOMC formally announced its plan to normalize and shrink its balance sheet in its June, 2011 meeting. Subsequent speeches, press conferences, and congressional testimony by Ben Bernanke have reinforced this understanding. The point is the Fed never intended the LSAPs to be permanent.

So again I ask, what do you see in the above figure? What is the bigger message it is telling? In my view, the answer to these questions is unambiguously clear. It signals the Fed never intended to unload both barrels of the gun and fully offset the collapse in aggregate demand. In other words, the figure reveals why Fed policy failed to end the slump.

This is a strong claim I am making. You may be scratching your heard wondering how I got that message out of the figure. Here is my explanation, based on previous posts. First, in order for there to have been sufficient aggregate demand growth the Fed needed to commit to a permanent monetary injection:

[O]pen market operations (OMOs) and helicopter drops will only spur aggregate demand growth if they are expected to be permanent. This idea is not original to Market Monetarists and has been made by others including Paul Krugman, Michael Woodford, and Alan Auerback and Maurice Obstfeld. Market Monetarists have been advocating a NGDP level
target (NGDPLT) over the past five years for this very reason. It
implies a commitment to permanently increase the monetary base, if
needed.

The key reason is that it would create an
expectation that some portion of the monetary base growth from the asset
purchases would be permanent (and non-sterilized by IOER). That, in
turn, would mean a permanently higher price level and nominal income in
the future. Such knowledge would cause current investors to rebalance
their portfolios away from highly liquid, low-yielding assets towards
less liquid, higher yielding assets. The portfolio rebalancing, in turn,
would raise asset prices, lower risk premiums, increase financial
intermediation, spur more investment spending, and ultimately catalyze a
robust recovery in aggregate demand. (One could also tell a New
Keynesian story where the higher future price level implies a temporary
bout of higher-than-normal inflation that would lower real interest
rates down to their market clearing level.)

The key to the above story is that some portion of the monetary base
expansion is expected to be permanent. If the public believes the Fed's
asset purchases are not going to be permanent and therefore the price
level and nominal income will not be permanently higher, the rebalancing
will not take place. I bring this up because this same point applies to helicopter drops or any other kind of fiscal policy stimulus.

Now to be clear, all that is needed is a commitment to permanently expand the monetary base if needed. But such a commitment, if credible, would most likely raise the velocity of the monetary base. In this case, the needed permanent monetary injection would be smaller. In other words, the figure above attests to the failure of the Fed policy not only because it shows a temporary increase in the monetary base, but also because it shows such a large increase in the monetary base. Had the Fed credibly committed from the start there never would have been the need for all the subsequent LSAPs. The Reserve Bank of Australia did just this and its economy was one of the few not hit by the prolonged economic slump.

Another way to see how the above figure reveals monetary policy failure is to compare the Fed to the Bank of Japan. It too tried temporary monetary injections but then switched to permanent ones under Abenomics:

[T]he Bernanke Fed never tried
Abenomics. That is, for all the Fed has done over the past five years it
never tried to do the kind of monetary regime change now being done by
the Bank of Japan. A year ago, Japanese monetary authorities shook
things up by credibly committing to permanently raising the nominal size of the Japanese economy. The evidenceso far
shows this program to be a smashing success. From the start, the
Bernanke Fed took the opposite approach. It credibly committed to a temporary expansion of its balance sheet. The U.S. monetary injections, therefore, were never intended to be permanent and this makes all difference in the efficacy of monetary policy.

So for all the praise the Bernanke Fed gets for preventing the second
Great Depression, it should be equally noted that it allowed the long
slump. By failing to do Abenomics for the U.S. economy, the Bernanke Fed
effectively kept monetary policy tight for the past five years. There is no other way to say it.

Okay, maybe there is another way to say it. The Bernanke Fed failed to
meaningfully address the
endogenous fall in the money supply and the decrease in money velocity.
The Bernanke Fed could have done an American version of Abenomics, like
nominal GDP level targeting, that would have arrested these
developments. Instead, it did not and
passively allowed total dollar spending to remain depressed. This
failure to act is no different than an explicit tightening of monetary
policy in terms of damage done to the economy. The only difference is
that the public is more aware of the explicit form.

55 comments:

The resulting extra (unexpected) inflation, of course, would have transferred tens or hundreds of billions of dollars in buying power from creditors to debtors -- notably from banks (and their shareholders) to lower-income households.

Money creation by commercial banks has no trouble creating aggregate demand , even though the threat always exists that the new money can be destroyed at a moment's notice by repaying the loan.

Maybe the Fed has noticed the fact that we've been creating ~2.5 dollars of debt for each dollar of gdp for a couple of years now - in other words , back to normal - and are wondering what's the point of balance sheet expansion , other than to further enrich the already filthy rich.

Inflation won't budge unless wages do so first. Abe gets this. When are the MMs going to catch on ?

Abstract: “Recent attention has turned from unemployment levels to wage growth as an indicator of imminent inflation. But is there any evidence to support the assumption that increased wages cause inflation? This study updates and expands earlier research into this question and finds little support for the view that higher wages cause higher prices. On the contrary, the authors find more evidence that higher prices lead to wage growth.”

The issue is far from being settled science , chiefly due , I suspect , to the confounding nature of debt ( i.e. money creation ) sunstituting for wage gains over the last several decades. We're now in the situation where that substitution is less likely to occur , and policymakers are beginning to come to their own conclusions , not because of some mis-specified Grainger causality result , but by using common sense.

Still , if you insist on playing the numbers game , this study finds causality from ULC to prices :

Both of these papers use Vector Error Correction Models (VECM) when testing for Granger causality. In my opinion, this is incorrect methodology.

Zapata and Rambaldi (1997, p.294) find that the Toda and Yamamato Wald test is clearly preferred to the likelihood ratio test used in the context of a VECM model, unless the sample size is extremely small.

http://onlinelibrary.wiley.com/doi/10.1111/1468-0084.00065/abstract

Clarke & Mirza (2006, p.207) find that "the practice of pretesting for cointegration can result in severe overrejections of the noncausal null, whereas overfitting [i.e. the Toda and Yamamato technique] results in better control of the Type I error probability with often little loss in power."

http://www.tandfonline.com/doi/abs/10.1080/07474939408800286

I've personally done Granger causality tests on ULC and PCEPI from 1947Q1 through 2013Q3 using the Toda and Yamamato technique and find PCEPI Granger causes ULC at the 1% significance level but that ULC does not Granger cause PCEPI (the p-value is 46.9%). This strongly confirms Hess and Schweitzer's results and largely contradicts Nourzad's results on ULC and PCEPI.

In response to your link I ran tests on ULC and CPI and find CPI Granger causes ULC at the 1% level and that ULC Granger causes CPI at the 5% significance level. Note that this is different from Nourzad's results of unidirectional causality from ULC to CPI. In any case I consider CPI to be a far inferior measure of consumer price inflation compared to PCEPI so the fact that there is any evidence of causality from ULC to CPI is not really persuasive to me.

In response to Hoxha, I also ran Granger causality tests on the German LCI and HICP and find no sign of causality in either direction.

I don't think the issue is my publishing record or even Anonymous's publishing record.

Gregory Hess and Mark Schweitzer find inflation causes wages and not the other way around. Hess is a top ranked economist (top 5% according to IDEAS) and this particular article has 30 citations. It confirms the results of other highly cited papers by top ranked economists (e.g. Robert Gordon, Yash Mehra, etc.)

Farrokh Nourzhad and Adriatik Hoxha find results that contradict the findings of these highly cited papers by top ranked economists. Who are Nourzhad and Hoxha? I have no idea. They aren't even ranked. Their papers are published in less than top ranked journals and only have one citation each. (For all I know they cited each other.)

Their econometric methods are highly questionable. See David Giles for more on why you should probably avoid doing VECM for Granger causality tests:

When I try and reproduce the results of the above papers using correct econometric methodology I verify the findings of the highly cited papers by highly ranked authors but largely contradict the findings in the barely cited papers by totally unknown authors.

Not only is this issue settled, it is dead and buried.

P.S. If wages have predictive value for inflation why is it that all of the currently used models of the Phillips Curve (New Keynesian Hybrid, Gordon Triangle, etc.) use lagged inflation rather than lagged wages as primary independent variables?

You can be hilarious sometimes. The very paper ( Hess ) you cite as the gold standard on wages vs inflation suffers from the problem of order of integration , highlighted in your Giles link. Wohar et al used Hess' data , correcting for the errors , and obtained different causality directions , dependent on the data regime studied :

Structural breaks are crucial in these time series. You can't simply disregard a period of wage and price controls , for example , nor a credit boom that supports consumption and prices even while wages may be slumping. Most economic studies of this type have tunnel-vision , ignoring the inconvenient confounders , only looking for the "right" result , and using whatever techniques they need to use to get them. You're a master at this , but still , not good enough to get in print beyond the blogosphere. Granger-away , though , you seem to have nothing better to do.

Most of these strong correlations - wages vs inflation , credit vs output , etc. - are bi-directional most of the time. They're feeding each other during growth phases , and can't be untangled precisely. Transitions are when things often become more clear , or unusual spells , like the ZLB deflationary one being experienced by much of the advanced world right now. It's clear that monetary policy can control inflation from below , but results to date suggest relative impotence at hitting a target from above. Luxury goods prices have been rising worldwide , while producers of normal consumer discretionary items have no pricing power. Thus , common sense says that the deflationary tendencies we see will not respond much more to the further enrichment of the rich , rather , we need demand lower down on the income scale , via wage gains ( not more debt ).

Abe has apparently flipped Sumner the bird. Exports , inflation , and the stock market are tanking , so he's going for what common sense tells him , and not listening to what the MM blobbering bloggers say :

"...Here, the wage surprise stands out, because only when the long-missing link between corporate profitability and wages is restored will investment in houses, cars, and other durables, and household consumption in general, finally rid Japan of its deflation and put its economy on a sustained growth path.

The wage surprise draws its inspiration from the Netherlands, where a consensus emerged in the early 1980’s that in order to sustain employment, the burden of taming rampant inflation should be shared by employers and the employed. That consensus was enshrined in the 1982 “Wassenaar Agreement,” named after The Hague suburb where it was forged.

Japan is now witnessing the emergence of a similar national consensus, or, rather, the Dutch consensus in reverse: a shared sense that the government, major industries, and organized labor should work together to increase wages and bonuses (while facilitating incentives that could enhance productivity)...."

"The very paper ( Hess ) you cite as the gold standard on wages vs inflation suffers from the problem of order of integration , highlighted in your Giles link. Wohar et al used Hess' data , correcting for the errors , and obtained different causality directions , dependent on the data regime studied."

The problem of structural breaks in the order of integration brought up by Sollis and Wohar is entirely different from the general problem with overrejection of noncausal nulls by VECM models. To understand the significance of what Sollis and Wohar are saying it might be useful to review Hess and Schweitzer's Granger causality test results.

The *only* positive result Hess and Schweitzer found with respect to the relationship between wages and inflation was that PCEPI Granger caused ULC. Everything else came up *negative*. A structural break in the order of integration could only result in a spurious positive result. Either that or it could result in a failure to find a positive result in some subperiod. And if that's the case, the result isn't very robust anyway, is it?

So basically there are only two possible important implications of Sollis and Wohar's findings for Hess and Schweitzer's results. Either PCEPI Granger causes ULC or it doesn't. That's not an outcome that supports the idea that wages cause inflation.

Incidentally, Sollis and Wohar only ran one series of Granger causality tests, just to illustrate what could go wrong. These tests involved employee compensation and the GDP implicit price deflator. They showed a failure to take into account the structural break in the GDP implicit price deflator in 1967 might result in a *spurious* result that employee compensation Granger causes the GDP implicit price deflator from 1959Q1 through 1979Q4. They also showed that breaking the period into two subperiods results in an *authentic* result that the GDP implicit price deflator Granger causes employee compensation from 1971Q4 through 1979Q4. Let me simplify that last remark to make it crystal clear: the only authentic Granger causality result they found was that *inflation causes wages*.

Incidentally Sollis and Wolner's tests suggest that there may be a structural break in the order of integration of PCEPI in 1967 and of ULC in 1990. The easiest thing to do in such a case is to simply break up the interval and actually test to see the orders of integration in the subintervals.

Using the ADF and KPSS unit root tests I find that level PCEPI is I(2) from 1959Q1 through 1967Q4, and from 1968Q1 through 1999Q3. So there is no structural break in the order of integration for PCEPI in 1967. I find that level ULC is I(1) from 1959Q1 through 1989Q4, and from 1990Q1 through 1999Q3. So there is no structural break in the order of integration for ULC in 1990.

But from 1981-99 the household sector ran a primary surplus every year apart from 1985 (Figure 7 in Mason). This was of course a period of declining labor share of income. So we don't see credit subsituting for income during 1981-99.

The biggest credit boom was actually the early postwar years of 1945-64 when the primary deficit average 2.3% of income during a period spanning 20 years. This was the period when the middle class moved to suburbia and went on a huge consumption binge on hosuses and cars. But labor share of income rose during this period, so rather than subsituting for decling wages, credit compelemented rising wages.

And just to round things out, 1965-80 was also a period when the household sector on average ran a primary deficit and labor share of income soared its peak level (67.0%) in 1980. And recall the period considered by Hess and Schweitzer was 1959-99. So during the entire time they examined credit was functioning as a complement to household spending, not a substitute.

Actually they're not. If you read Hess and Schweitzer and the main body of literature on the relationship between wages and inflation (Gordon 1988, Mehra 1991, 1993, 1999, Huh and Trehan 1995, Rissman 1995 etc.) there is either little sign of Granger causality or it is almost always one way from inflation to wages.

Similarly there is a whole body of literature on endogenous money that shows that shows the direction of causality almost always runs from private sector spending to credit and not from credit to spending. My own estimates show for example that from 1993Q1 through 2013Q2 private nonresidential fixed investment (PNFI) Granger causes business sector loans and securities at the 5% significance level, and commercial bank loans and leases Granger causes PNFI and private residential fixed investment (PRFI) at the 5% significance level each. That private sector credit is endogenous to the state of the economy is another extremely well established empirical fact.

"Transitions are when things often become more clear , or unusual spells , like the ZLB deflationary one being experienced by much of the advanced world right now. It's clear that monetary policy can control inflation from below , but results to date suggest relative impotence at hitting a target from above."

There has been a great natural experiment going on since the Great Recession. The US, the Euro Area, Japan, the UK, Sweden have each hit the zero lower bound and engaged in their own monetary exercises. Countries that started early and continued until recently doing QE, such as the US and the UK, lead in terms of NGDP growth and have seen a huge reduction in debt leverage levels. In the UK the problem until recently has been, if anything, too much inflation, not too little. The Euro Area has never done any QE and its economy has totally floundered. Consequently debt leverage is at record levels. Japan is late in doing QE but already has experienced a year on year tax-adjusted core-core inflation last exceeded in March 1995, and unemployment has dropped to 3.6% which was last lower in January 1998. And the stuff about Japan's trade deficit is *good news* because it indicates rising domestic demand. The only currency area that has seen virtually every member shift to a trade surplus is the Euro Area, because they are experiencing a nearly universal domestic demand depression. Sweden had by far the most expansionary monetary policy from September 2008 to June 2010 and it surged far into the lead in terms of NGDP growth by 2010Q4. But since completely unwinding QE and sharply increasing its policy rate its economy has floundered. And Sweden's debt leverage sharply plunged from 2009Q3 to 2010Q4, but has been rising since, and household sector debt leverage is now at record levels.

"The *only* positive result Hess and Schweitzer found with respect to the relationship between wages and inflation was that PCEPI Granger caused ULC. Everything else came up *negative*. A structural break in the order of integration could only result in a spurious positive result. Either that or it could result in a failure to find a positive result in some subperiod. And if that's the case, the result isn't very robust anyway, is it?"

Exactly. And yet you claim this is settled science , in spite of the lack of robust results. My contention has been that sub-periods matter. Transitions matter. Once-a-century ZLB deflationary episodes matter. What we want to know today is whether we're in one of those periods when the lack of wage growth is the causative factor in the deflationary trends we see. None of your Granger gyrations comes close to providing an answer to that question. The early-to-mid-80's was another such period that could have provided the answer , given the collapse in wages that occurred then , but it was obscured by debt , and debt is something that scarce few economists paid any attention to prior to the crisis , and specifically your boy Hess ignores it completely. BTW , he gets no credit for accounting for wage and price controls. Only a true moron would miss that.

On to the '80s hh credit boom. Yes , "boom". I don't expect to convince you , nor for you to admit to it if I did , so I offer this for others who may actually have an open mind about what the facts say.

Mason' work may have some merit for some purposes , but it's crap for looking at the impact of hh debt on output , because of the way he treats housing outlays , and this is especially important for the '80s. A residential housing boom was a major force in ending the recession , and was coupled , with a normal lag , to a hh home-buying and credit boom in the mid-80s. Demand could not have been maintained absent this credit boom , and its presence was widely recognized at the time. People who lived through it remember it as a trial run for the 2000s debacle - the same low standards by appraisers , underwriters , etc.

Here's Volcker in 2/86 , on economic performance in the year prior :

"...consumers continued to increase their spending at a substantial clip, but only by borrowing at a pace that pushed household debt burdens to still higher levels."

Nowadays , we can easily view the relevent data directly , using FRED. This shows the annual % growth in household leverage ( i.e. debt/dpi ) , in blue. The debt is **net of interest paid**. I also show annual % change in production and nonsupervisory wages , in red ( right scale ) :

http://research.stlouisfed.org/fred2/graph/?g=y9S

The increase in hh leverage in the mid-80s rivals that of the 2000s in rates of growth , while at the same time hourly wages for most workers were tanking. This is the sort of dynamic that pisses all over your Granger calcs.

If you want to look at someone who is going to great lengths to disaggregate debt , incomes , and savings across the distribution , and how it impacts output over time , a better source than Mason is Fazzari and Cynamon. Unlike some , they show all their work. See , for example :

"Exactly. And yet you claim this is settled science , in spite of the lack of robust results. My contention has been that sub-periods matter. Transitions matter."

If you have to stoop to data fishing for periods with positive results, those results are spurious. In any case, Mehra has already tried subdividing the US postwar period and found that this actually decreased the already weak statistical significance of the effect of wages on inflation. Moreover he found that the statistical significance of the effect of wages on inflation was less in low inflation periods than in high inflation periods.

"BTW , he gets no credit for accounting for wage and price controls. Only a true moron would miss that."

You mean sort of like how you missed the fact that Hess and Schweitzer actually accounted for it?

"Mason' work may have some merit for some purposes , but it's crap for looking at the impact of hh debt on output , because of the way he treats housing outlays , and this is especially important for the '80s...If you want to look at someone who is going to great lengths to disaggregate debt , incomes , and savings across the distribution , and how it impacts output over time , a better source than Mason is Fazzari and Cynamon."

This is precisely backwards. Mason extends the public debt framework to the household sector, which is exactly what you would want to do if you were trying to estimate the household sector “fiscal deficit”, which in turn is necessary if one wants to know the impact of household sector debt on output. The focus of Fyzzari and Cynamon's paper is on aligning NIPA macroeconomic data with microeconomic data collected from the CPS, SCF and PSID surveys, not on debt. In fact the word "debt" only appears four times in the entire content of their paper. In contrast the word debt appears 12 times in Mason's abstract alone.

"...consumers continued to increase their spending at a substantial clip, but only by borrowing at a pace that pushed household debt burdens to still higher levels."

Nobody doubts that household sector debt leverage increased in the 1980s. The question is why? Mason does the hard work and concludes the following (Page 23):

"1981-1999 During this period, households switched to primary surpluses, but as a result of financial deregulation and higher interest rates following the Volcker shocks, household debt ratios rose at about half the rate of the postwar years (1.4 percent annually compared with 2.6 percent). This increase took place despite primary surpluses averaging 1.4 percent of household income. With growth rates essentially unchanged from the previous period, the growth of leverage was entirely due to higher real interest rates, with higher nominal interest rates contributing two thirds of the increase and lower inflation the other third. It is striking to realize that over this period, accounting for about half of the post-1980 increase in leverage, saw the lowest levels of household spending relative to income of the whole postwar period. Leverage rose only because of the effect of higher real effective interest rates on households' existing stock of debt."

The bottom line is that the 1980s was a period of "fiscal austerity" for the household sector. The only reason why household sector debt leverage rose was because of higher real effective interest rates due to financial deregulation and tight monetary policy.

Residential investment in the 1980s peaked at 5.23% of GDP in 1986Q4. There are 20 quarters (5 years!) in the 1950s, 19 quarters in the 1970s and 15 quarters in the 1960s when residential investment exceeded that. Even the increase in house prices wasn't all that remarkable. The real All-Transactions House Price Index increased by 14.6% from 1982Q3 to 1989Q4. By comparison real house prices increased by 20.2% from 1976Q1 to 1979Q2, before falling 9.5% by 1982Q3. Consequently at peak in 1989Q4 real house prices were only 3.8% above their previous peak in 1979Q2.

Rather than a residential investment boom, what happened in the 1980s was a residential investment depression. In fact home ownership fell for the first time since the Great Depression:

It fell all the way to 63.6% by 1986Q1 which was lower than it was in 1966Q4, nearly 20 years earlier. Even as late as 1994Q2, eight years after that, the homeownership rate was still only 63.8%. It wasn't until 1998Q2 that home ownership recovered to the level that it had been in the 1979Q2, 19 years previously.

The only reason why residential investment contributed so much to the recovery from the 1982 recession was the fact that it had fallen 45.5% as a share of GDP between 1978Q3 and 1982Q2, which was easily the greatest collapse in residential investment since the Great Depression. It had nowhere to go but up.

“Nowadays , we can easily view the relevent data directly , using FRED. This shows the annual % growth in household leverage ( i.e. debt/dpi ) , in blue. The debt is **net of interest paid**. I also show annual % change in production and nonsupervisory wages , in red ( right scale )”

If the intent of your formula is to calculate the primary balance, it is woefully incorrect. Your formula reads:

(a-b)/c

Where a=debt, b=interest and c=income. To that you apply “percent change from the previous year”. This will give you the percent change in household sector debt less interest payments over income for the given year. Of course this was usually positive in the 1980s and 1990s. Debt Leverage went up.

What we need to calculate is:

[(∆a-b)/c]*100

Change in debt less interest paid is the amount of new borrowings in a given year, or the primary deficit. Dividing this by income and multiplying by 100 renders it as a percent of income.

With these adjustments we get the following:

https://research.stlouisfed.org/fred2/graph/?graph_id=174003

Compare that with the primary deficit (red line) in Figure 7 of Mason’s paper:

http://repec.umb.edu/RePEc/files/FisherDynamics.pdf

It’s virtually a perfect match. Notice that the household sector ran a primary surplus every year from 1981 through 1999 with the sole exception of 1985.

Now to see why this makes sense let’s consider a particular year, say 1987. According to your formula the rate of change in debt less interest paid divided by income is 5.2%. But according to the formula I just posted the primary deficit was (-1.1%) of income (negative means a primary surplus). Let’s look at the actual figures.

Debt rose from $2412 billion in 1986 to $2656 billion in 1987. Interest was $272 billion in 1986 and $283 billion in 1987. Income rose from $3288 billion in 1986 to $3466 billion in 1987.

The change in debt was $244 billion. Thus the primary surplus was $39 billion which is of course 1.1% of $3466.

Household leverage rose from 73.3% in 1986 to 76.6% in 1987. Debt less interest paid divided by income (your formula) rose from 65.0% in 1986 to 68.4%. The percent change in that ratio is 5.2%. This is pretty close to the percent change in household leverage (4.5%), but this is still not the same as the primary deficit, and it tells us almost nothing about the borrowing behavior of the household sector that year.

You are indeed correct , I did mess up that calculation. The excessive interest payments wiped away most of the impact of new debt during that period. My apologies on this one , and to Mason as well.

The question remains as to what the impact on spending would have been if leverage had been held constant , but that's more a question about overall leverage , not household. Total nonfinancial leverage is holding constant now , and has since the crisis. It was essentiallyconstant in the '90s , and really for the entire post-War period , aside from the '80s and 2000s. I have to wonder if we had held to a fixed leverage limit througout , via tighter lending standards , if that wouldn't have resulted in an eventual fall in interest rates , resulting in less interest paid , and greater efficiency of debt-to-gdp conversion.

Thru the 90s , Greenspan always mentioned nonfinancial credit growth guidelines in his reports , typically something like a range of 3-9% , which , given ngdp growth of 5-6% , would tend to keep leverage about constant. I don't think he paid any attention to it in the 2000s. I suspect the reason is mainly political , rather than technical , and that he hoped to set up a nice economy for Bush and the Repubs in '04 and beyond.

For the last few years before he left the Fed , Volcker was constantly hectored in hearings about growing leverage and he would say " Yes , I agree ! " , but he didn't move to limit that growth. So he's a hero now , but I'm not so sure that he deserves all the accolades. He left a bit of a mess for the next guy , just like Greenspan. Carney may be doing something similar in the U.K. right now.

The other interesting thing to me on the interest paid issue is that in order to believe that the interest paid reduces potential consumption , you have to believe that the receivers of the interest have a significantly lower MPC than the payers. I don't have any problem with that concept , but it's pretty big news if you've accepted that view.

A quick follow-up to note that , upon reflection , your analysis of hh primarybalance makes no sense as regards the growth-stimulating benefit of new debt. By extension , the same applies to Mason's work , assuming he uses the same reasoning you suggested above.

Take the case of the gov't budget balance. If the gov't had a balanced budget and a debt of 100% of gdp , paying interest at 2% , you'd have the following for "Year 1 ", setting the budget at 20% of gdp . ( all #'s in % of gdp )

Year 1 : Income (20) - Outgo (20 ) = Balance (0)

Outgo (20) = Spending ( 18 ) + Interest ( 2 )

Balance (0) + Interest ( 2 ) = Primary Balance ( 2 )

Debt ( 100 )

Now , if year 2 looked exactly like year 1 , you'd say there was no stimulus, i.e. the primary balance in year 1 (2) - primary balance in year 2 (2) = 0

So , nearly a full 2% stimulus from the 2% in new borrowing , decremented only by the additional financing costs associated with the new money. This is entirely conventional , and it's the same way we should look at new borrowing by the private sector. But your method , described above , subtracts the entire , accumulated-debt interest burden from the new borrowing , which , using my gov't example , would yield a year 2 stimulus of negative .04% of gdp , rather than the correct answer of plus 1.96 % of gdp.

So , if Mason is using your method :

"Change in debt less interest paid is the amount of new borrowings in a given year, or the primary deficit. "

.... then my first impression was right - his stuff is crap for purposes of delineating debt-generated demand. "Change in debt - change in interest paid" is the correct calculation to determine the amount of new debt that would be available to contribute to new spending , just as in my gov't example above. Here's what your graph - which corrected my initial erroneous graph - looks like , done right , finally. ( third time's the charm ? ) :

http://research.stlouisfed.org/fred2/graph/?g=yw8

Back to normal. Yes , new credit can still stimulate demand , even after accounting for interest paid.

That doesn't mean I think we should be encouraging new hh credit. Just the opposite , I think hh's should deleverage further - a lot further. But , that's a different story.....

"The question remains as to what the impact on spending would have been if leverage had been held constant , but that's more a question about overall leverage , not household."

It depends on how the leverage is held down. If it is done by holding down real effective interest rates without increasing the primary balance, then it will have little negative effect on spending.

"Total nonfinancial leverage is holding constant now , and has since the crisis. It was essentiallyconstant in the '90s , and really for the entire post-War period , aside from the '80s and 2000s."

True, but why exclude the financial sector? Financial sector leverage has fallen 30.7% from peak in 2009Q1 and household sector leverage by 19.7%. Consequently total leverage is down 9.4%. This is the first significant decline in financial sector leverage since 1933-49, the first significant decline in household sector leverage since 1933-45 and the first significant decline in total leverage since 1933-51.

"I have to wonder if we had held to a fixed leverage limit througout , via tighter lending standards , if that wouldn't have resulted in an eventual fall in interest rates , resulting in less interest paid , and greater efficiency of debt-to-gdp conversion."

High debt leverage is correlated to financial deregulation, financial innovation and tight monetary policy. Tighter credit standards may be part of the solution, but I suspect that a partial return to the outright "financial repression" of the 1930s-1970s, in the form of interest rate ceilings, the partitioning of financial markets and capital account restrictions, may also be needed. In addition real effective interest rates were driven up to record levels in 1982-2002 by tight monetary policy during the two significant periods of disinflation in 1980-86 and 1990-98. Thus a somewhat more expansionary monetary policy is needed too.

"Thru the 90s , Greenspan always mentioned nonfinancial credit growth guidelines in his reports , typically something like a range of 3-9% , which , given ngdp growth of 5-6% , would tend to keep leverage about constant. I don't think he paid any attention to it in the 2000s."

Credit growth is an indicator of nominal income growth. This was probably just one more piece of information that Greenspan consulted in the formation of monetary policy. I doubt he was actually targeting debt leverage.

"The other interesting thing to me on the interest paid issue is that in order to believe that the interest paid reduces potential consumption , you have to believe that the receivers of the interest have a significantly lower MPC than the payers. I don't have any problem with that concept , but it's pretty big news if you've accepted that view."

I can only speak for myself, but it seems to me the idea that one of the several channels that the Monetary Transmission Mechanism (MTM) works through is the Cash Flow Channel is standard textbook monetary economics (e.g. Mishkin):

A monetary contraction that raises real effective interest rates to consumers leads to a decline in spending on consumer durables and housing. A decline in consumer cash flow increases the risk of financial distress, which reduces the desire of consumers to hold durable goods or housing, thus reducing spending on them and hence aggregate output. As with the Household Liquidity Effects Channel, under the Cash Flow Channel it is not the lenders' unwillingness to lend which causes spending to decline but the consumers' willingness to spend.

As you note this only really makes sense if you believe that the receivers of interest have significantly lower MPC than payers. I don't think that's too farfetched given the distribution of interest received and paid in the household sector.

According to Edward Wolff, the top 1% of households by wealth class only owed 5.4% of the debt in 2007 (page 51):

http://www.levyinstitute.org/pubs/wp_589.pdf

That same year the household sector received about $651 billion in monetary (taxable) interest and $701 billion in imputed (nontaxable) interest:

Of the imputed interest received approximately $255 billion was from life insurance, $251 billion from pension funds and $181 billion was from banks, credit agencies and investment companies. So about 48.2% was taxable, 18.9% was from life insurance, 18.6% from pensions funds and 13.4% from other nontaxable sources.

According to Arthur Kennickell, in 2007 the top 1% by income class received 38.0% of the taxable interest income and 55.6% of the (other) nontaxable interest income received by households (Page 78):

http://www.federalreserve.gov/pubs/feds/2009/200913/200913pap.pdf

And if you look at the same table in in the Edward Wolff paper I cited above you'll see that in 2007 the top 1% by wealth class held 22.0% of the life insurance and 14.4% of the pension funds.

Obviously the top 1% by wealth class and by income class are not identical, but a weighted average suggests the top 1% receive nearly a third of all household sector interest received and pay only about 5% of all household sector interest paid. Thus changes in real effective interest rates may be viewed as transfers in income between vastly different income/wealth classes.

"But your method , described above , subtracts the entire , accumulated-debt interest burden from the new borrowing , which , using my gov't example , would yield a year 2 stimulus of negative .04% of gdp , rather than the correct answer of plus 1.96 % of gdp."

The government paid less in principal in year 2, but no new borrowing took place. The primary surplus went from 2.00% of GDP in the first year to 0.04% of GDP in the second. The degree of fiscal stimulus is the *change* in primary balance, which is 1.96% of GDP in year 2. But a primary surplus was run in both years.

"Back to normal. Yes , new credit can still stimulate demand , even after accounting for interest paid."

Let's take a closer look at your new formula and see why it's even worse than your previous formula.

Suppose in year t=0 that debt is $100, income $20, non-interest spending $18 and interest 2% so the interest on the debt is $2.

Suppose that in year t=1 the interest rate doubles to 4% because of financial deregulation and tight monetary policy. But income and non-interest spending remain the same. Thus debt will rise to $102.08 to cover the interest of $4.08 on the current debt. The change in debt is $2.08 and the change in interest is $2.08 so by your formula the primary balance is $0.

In year t=2 let's suppose income, non-interest spending and the interest rate remain the same. Thus debt will rise to about $104.25 to cover the interest of $4.17 on the current debt. The change in debt is $2.17 and the change in interest is $0.09 so by your formula the primary deficit is $2.08.

But note that absolutely nothing has changed. Revenues and non-interest spending are exactly the same as they were the previous two years. Even the interest rate is the same as the previous year. But your formula suggests that household spending was simulative in year t=2.

In fact the primary surplus is $2 in year t=0. In year t=1 the primary surplus is the interest of $4.08 less the change in debt of $2.08 and so it is still equal to $2. In year t=2 the primary surplus is the interest of $4.17 less the change in debt of $2.17 and so it is still equal to $2.

This makes sense since the difference between income and non-interest spending is $2 in all three years.

You should also realize that changes in the cyclically adjusted primary balance are the most widely accepted way of estimating the degree of fiscal stimulus (Page 105):

"The change in the primary balance-to-GDP ratio as a comprehensive indicator for the fiscal impulse

Accordingly, given the pros and cons of the different alternatives, the changes in the headline balance or in the primary balance, as a percentage of GDP, would be the most comprehensive and, at the same time, manageable indicators for the impulse provided by public finances. They offer two main advantages. Firstly, they include the reaction of automatic stabilisers to the economic situation, whose functioning, in general, involves non-negligible economic effects on the private sector without the risk of incurring pro-cyclical policies. This also implies that contemporary feedbacks between macroeconomic and fiscal developments, transmitted via fiscal multipliers and automatic stabilisers, are accounted for. Thus, the indicators might be interpreted as a “net fiscal stimulus”. Secondly, as the government deficit is made public and is subject to wide scrutiny, this indicator is easier to monitor and appears less open to manipulation than others. Moreover, in view of the interest in the role of fiscal policy and the economic effects of the impulse, it can be accompanied by useful information on the different budgetary sources behind it and the transmission channels thereof."

Cyclically adjusted measures of the household primary balance don't exist. In fact I'm not sure it would be wise or even possible to cyclically adjust the household sector primary balance. In any case Mason and Jayadev’s paper is the first to my knowledge that has extended the public debt framework to the household sector. And it has done so entirely correctly.

You're killing me. I just got around to reading your link on fiscal impulse measurement. Did you even read what you posted ? First you tell me :

"You should also realize that changes in the cyclically adjusted primary balance are the most widely accepted way of estimating the degree of fiscal stimulus (Page 105) "

Then you quote the paper advising otherwise :

" Accordingly, given the pros and cons of the different alternatives, the changes in the headline balance or in the primary balance, as a percentage of GDP, would be the most comprehensive and, at the same time, manageable indicators for the impulse provided by public finances."

On p.109 they repeat the recommendation :

"4. A suggested approach to analysing a fiscal stimulus

In view of the pros and cons of the various alternatives, the year-on-year changes in the headline balance or in the primary balance-to-GDP ratios are the suggested indicators to measure the fiscal stimulus...."

Mostly the paper talks about the disadvantages of CAPB as an impulse measure , and the reasons for including automatic stabilizers in the impulse measurement , rather than excluding them with the CAPB measure :

"A more general downside of focussing on changes in CAPBs is that by neglecting the effect of automatic stabilisers, this indicator fails to account for important macroeconomic effects of government finances. Countries with extensive social protection coverage and with large automatic stabilisers contribute a sizeable counter-cyclical economic impulse without the need for recourse to additional discretionary measures. In this regard, based solely on the adoption of discretionary measures, the conclusion might be drawn that “the government does little” to overcome the economic downturn, when, in fact, if the financial flows stemming from the operation of automatic stabilisers were also accounted for, the con­clusion could be quite the opposite. Moreover, the operation of automatic stabilisers may, in many respects, represent more timely policy actions than discretionary ones, thereby avoid­ing the risk of incurring pro-cyclicality.

Accordingly, a broad definition of fiscal stimulus including the operation of auto­matic stabilisers enjoys some advantages with respect to the other alternatives. Spe­cifically, it is easier to implement in practice, it is less restrictive as regards the concepts entering the definition, it facilitates comparability between countries with different social protection schemes and tax systems, and it incorporates important elements from a policymaker’s standpoint........ ( this is the part you really won't like ) .......As the government deficit is made public and is subject to wide scrutiny, this indicator appears less open to manipulation than others. "

So , as I've been saying all along - the crucial measurement is the year-on-year change in the budget balance , whether headline or primary.

And why would a private sector impulse be treated any differently ? It won't be , if people are thinking clearly.

"Rising inequality reduced income growth for the bottom 95 percent of the income distribution beginning about 1980, but that group’s consumption growth did not fall proportionally. Instead, lower saving led to increasing balance sheet fragility for the bottom 95 percent, eventually triggering the Great Recession. We decompose consumption and saving across income groups. The consumption-income ratio of the bottom 95 percent fell sharply in the recession, consistent with tighter borrowing constraints. The top 5 percent ratio rose, consistent with consumption smoothing. The inability of the bottom 95 percent to generate adequate demand helps explain the slow recovery."

Mason missed the boat with his analysis by not looking at debt and income distribution effects. The big regime change since WWII was not any of the ones Mason mentioned , it was Reagan's supply-side debacle and the acceleration of upward redistribution of incomes.In a way I can't blame Mason for not addressing the inequality issue - he probably figured it would have gotten him nothing but publisher rejection letters.

Fazzari and Cynamon have a website with more discussion about the inequality - debt linkage that's well worth perusing , for those who want to learn about the real causes of our current predicament :

"In public debt decompositions, the primary balance is generally taken to be exogenous. Itis not clear that this is a better assumption for the public sector than for other sectors.Certainly, if one were to adopt a model of an optimizing household with perfect foresightas to the trajectories of interest, in inflation and income, and the ability to adjust its expen-diture decisions instantaneously and costlessly, such an assumption would be nonsensical.Alternatively one could take another extreme case, and regard consumption out of incomenot as the result of any kind of optimizing process, but as a behavioral parameter that mustbe explained in sociological terms. Hypotheses of this kind have been put forward by anumber of researchers regarding the last few decades of consumption behavior.(Cynamonand Fazzari, 2008)"

"Extreme case" ?

Is that Mason taking a potshot at Fazzari ? Is it anywhere near as extreme to say that decisions about consumption out of income might have behavioral origins than it is to say that it's an act of an "optimizing household with perfect foresight as to the trajectories of interest, in inflation and income, and the ability to adjust its expenditure decisions instantaneously and costlessly" ??

"You're killing me. I just got around to reading your link on fiscal impulse measurement. Did you even read what you posted ? First you tell me :

"You should also realize that changes in the cyclically adjusted primary balance are the most widely accepted way of estimating the degree of fiscal stimulus (Page 105) "

Then you quote the paper advising otherwise :

" Accordingly, given the pros and cons of the different alternatives, the changes in the headline balance or in the primary balance, as a percentage of GDP, would be the most comprehensive and, at the same time, manageable indicators for the impulse provided by public finances."

On p.109 they repeat the recommendation..."

Explain to me in a coherent manner how

"changes in the cyclically adjusted primary balance are the most widely accepted way of estimating the degree of fiscal stimulus"

is at all contradicted by

"changes in the headline balance or in the primary balance, as a percentage of GDP, would be the most comprehensive and, at the same time, manageable indicators for the impulse provided by public finances"

"BTW , you didn't like the Fazzari / Cynamon paper I linked to last time , because it didn't talk enough about debt. Try this one."

Two things really bother me about this paper by Cynamon and Fazzari. One is it implies that consumption relative to income was rising from the late 1960s on forward (Figure 2) and the other is that it implies that consumption to income is much lower in the top 5% of the population than the bottom 95% (Figure 5).

Figure 2 looks at the ratio of PCE to DPI and it is entirely correct. However it excludes two really important things that happened in the 1980s: the plunge in property taxes and the huge increase in mortgage interest payments. This is because, as Mason notes (Page 10) property taxes are not deducted from disposable personal income, and as Cynamon and Fazzari note (Footnote 17):

"The BEA treats mortgage interest for homeowners as a deduction from personal income rather than a transfer to be consistent with the implicit rent method of measuring homeowner consumption of housing services."

To be crystal clear, DPI includes imputed rental income from home ownership, which in turn subtracts mortgage interest.

You can see property taxes were sharply lower in the 1980s compared to the 1970s and mortgage interest was sharply higher. If DPI excluded imputed rental income and subtracted property taxes, and PCE excluded imputed rent, you'd get a rather different picture of the ratio of consumption to income:

https://research.stlouisfed.org/fred2/graph/?graph_id=174615

In fact by this measure personal consumption as a ratio of income was lower in the 1980s than at anytime prior to 1970, which is consistent with Mason's estimates of the relative primary deficit across time.

As for Figure 5 it only starts in 1989 so it tells us absolutely nothing about the ratio of consumption to income in the 1950s, 1960s, 1970s or the 1980s. More importantly it counts capital gains as income. Capital gains is not part of GDP (nor should it be) and so any measure that includes it as income is hugely flawed from the standpoint of macroeconomic demand analysis.

From 1989-2012 capital gains made up 2.0% of taxable income for the bottom 95% and 14.2% of income for the top 5% according to Piketty and Saez. Eyeballing Figure 5 I would guess that consumption as a percent of income averaged about 91% for the bottom 95% and about 83% for the top 5%. Remove capital gains income and the disparity in the consumption ratio totally disappears.

But the bottom line is that Cynamon and Fazzari don't even address the causes of the fundamental shift in household debt leverage dynamics, which begins a whole decade earlier than where they pick up.

"Mason missed the boat with his analysis by not looking at debt and income distribution effects. The big regime change since WWII was not any of the ones Mason mentioned , it was Reagan's supply-side debacle and the acceleration of upward redistribution of incomes.In a way I can't blame Mason for not addressing the inequality issue - he probably figured it would have gotten him nothing but publisher rejection letters."

Mason shows why household debt leverage increased despite the fact the household sector primary balance shifted from deficit to surplus between the 1970s and the 1980s. It's explained entirely by the huge increase in real effective interest rates between the two decades, and it has absolutely nothing to do with rising levels of inequality. (In fact, if anything, higher real effective interest rates can be viewed as a *cause* of rising net wealth inequality.) It would be nice to extend Mason's analysis by disaggregating it by income level. But that's a topic for a whole other paper.

"If DPI excluded imputed rental income and subtracted property taxes, and PCE excluded imputed rent, you'd get a rather different picture of the ratio of consumption to income"

If , if , if.

Can we all play this game ? I think high oil prices had so depressed consumers by 1980 that they remained curled in a fetal position in bed all day. They would surely have done much more shopping if this had not been the case , so I want extra PCE for that entire period until gas prices normalized.

If you subtract your "adjusted" DPI from GDP , and do the same with the official DPI and compare the results , you'll find that , to date , you've totally vaporized over $1 trillion of disposable income. Poof ! Where did it go ?

Let's assume it's out there somewhere. What if we look at PCE expenditures as a share of gdp , and compare that with your "adjusted" figures. Using GDP instead of DPI will capture all incomes , including any that may have gotten misplaced by you , Mason and countless others. Let's look at annual change in PCE as a share of GDP so we have a track to follow , and see whether your "adjusted" PCE/DPI measure tracks it as well as the standard PCE/DPI measure. You can tweak the factor applied to the PCE/GDP curve any way you like to get the best match. Your curves are green/blue on top and left scale , the standard data are on the bottom , right scale :

http://research.stlouisfed.org/fred2/graph/?g=yVo

As you can see , that missing $1 trillion makes a difference.

Let's face it , if you get to yank the data any way you want , it will reveal whatever you want. This is the problem with work like Mason's - there's no way to tell if stuff has just disappeared into the ether. If he had run the complete sectoral data - i.e. business , gov't , and current account as well as households - using the same methods , and then showed that it all netted to zero as it should in any proper sectoral balance model , that would be a lot more convincing.

"changes in the cyclically adjusted primary balance are the most widely accepted way of estimating the degree of fiscal stimulus"

You do know that "headline" and "primary" refer to different measues than "CAPB" , don't you ? Let's assume not , and review again from the link you so generously provided. I'll bracket some of the more important stuff , > < , thusly , as I know you tend to drift off at times :

Summary and conclusions:

>The term “fiscal stimulus” or “fiscal impulse” (used here as synonyms) generally refers to the additional financial impact of government finances on the economy relative to a reference situation, be it the previous year or a baseline scenario. < Its measurement depends largely on what it is intended to measure and the question to be answered.

The stimulus provided by government and its effect on the economy:

A fiscal impulse arises from financial flows between the general government and the private sector, which are in general reflected by budgetary developments. Therefore, it is straightforward to measure the impulse on the basis of changes in the government budget. This input-side definition/measurement appears relatively easy to adopt in practice and may yield relatively comparable results across countries. Since an important concern when analysing a fiscal impulse is its effect on macroeconomic developments, an output-side definition of fiscal stimulus puts the emphasis on the ultimate results (or effect) of government actions on economic performance. According to this approach, the appraisal of a fiscal stimulus should ideally be based on model-based output responses or econometrically estimated multipliers/PUEs (projection update elasticities). While it would assess directly to what extent governments comply with their stabilising roles, this approach has a number of drawbacks. Specifically, the lack of a manageable model-based framework or of PUEs based on a common methodology available to assess the macroeconomic effects of initial fiscal impulses in different countries in a transparent and comparable way and the estimation uncertainty surrounding fiscal multipliers raise serious doubts about its and the estimation uncertainty surrounding fiscal multipliers raise serious doubts about its practical implementation in a multi-country context.

>A customary approach in the discussion on fiscal stimuli is to focus on the financial impact of a given set of measures on the general government balance.< However, this option is >very selective, may give only a partial view of the relevant fiscal developments and is prone to varying classifications, or even manipulation, in international comparisons.< For example, the consideration of the fiscal stimulus stemming from the measures under the European economic recovery plan without taking account of other stimulus sources is highly selective and might lead to very arbitrary outcomes when the “effort” of different countries is assessed.Alternatively, if interest lies in the effects of >discretionary fiscal policies< overall, the changes in cyclically adjusted (primary) balances (CA(P)Bs) might be considered as a relevant proxy. >These are obtained by netting out the effect of automatic stabilisers. < This measurement could be interpreted as a genuine one-sided impulse from government finances to the rest of the economic sectors. However, the effects of the cycle on fiscal balances are difficult to assess, and the existing methods tend to assign to the structural part changes in some fiscal variables (revenue windfalls/shortfalls) whose nature is, at least in part, cyclical. More generally, besides discretionary fiscal policy measures, > the CAPB is affected by structural or temporary developments outside the government’s control and is, therefore, a >very imperfect measure of active fiscal policy<. Furthermore, insofar as changes in CAPBs >neglect the effect of automatic stabilisers< , this indicator > may lead to misjudgement of the stabilising role of government finances, especially in the case of countries with sizeable automatic stabilisers < and in cross-country comparisons.

The change in the > primary balance-to-GDP < ratio as a comprehensive indicator for the fiscal impulse:

Accordingly, > given the pros and cons of the different alternatives, the changes in the >headline balance< or in the >primary balance<, as a percentage of GDP, would be the most comprehensive and, at the same time, manageable indicators for the impulse provided by public finances. They offer two main advantages. Firstly, they> include the reaction of automatic stabilisers < to the economic situation, whose functioning, in general, involves non-negligible economic effects on the private sector without the risk of incurring pro-cyclical policies. This also implies that contemporary feedbacks between macroeconomic and fiscal developments, transmitted via fiscal multipliers and automatic stabilisers, are accounted for. > Thus, the indicators might be interpreted as a “net fiscal stimulus”. <Secondly, as> the government deficit is made public and is subject to wide scrutiny, this indicator is easier to monitor and appears less open to manipulation than others. < Moreover, in view of the interest in the role of fiscal policy and the economic effects of the impulse, it can be accompanied by useful information on the different budgetary sources behind it and the transmission channels thereof. "

"Can we all play this game ? I think high oil prices had so depressed consumers by 1980 that they remained curled in a fetal position in bed all day. They would surely have done much more shopping if this had not been the case , so I want extra PCE for that entire period until gas prices normalized."

My point was that DPI and PCE already make significant adjustments concerning the treatment of housing. Because of these adjustments, the sharp decline in property taxes and the huge increase in mortgage interest in the 1980s serve to conceal a significant decline in consumption relative to income when compared to previous decades. If one is aware of these adjustments, the seeming inconsistency between the pattern observed in the PCE to DPI ratio, and the pattern observed with the primary balance, is easily reconciled.

As for your latest attempt at FRED, you are dividing the change of a nominal quantity by a level nominal quantity in all four lines. This is almost 100% guaranteed to show a rise through 1980, and then a fall since, for the simple reason that inflation peaked in 1980.

I don't know what this is supposed to show except that this further confirms my opinion that you have no idea at all what you are doing.

All of the measurements have legit uses , for example , when doing long-term budget planning you'd want to account for the impact of structural deficits , interest and inflation , etc. I'm not against the use of cyclically- or structurally-adjusted budget measurements as long as they're not being used for nefarious purposes. For example , if you're the IMF and you're trying to run your typical shock-doctrine , austerity-imposing rape of some 2nd- or 3rd-tier economy , the use of these measures allows you to convince people that austerity won't hurt at all , because , you see , all that money you spent when the recession hit wasn't really "stimulus" anyway.

Similarly , some economists will manipulate these figures in attempts to prove that fiscal policy is completely impotent , .and that it's all monetary , all the time. I won't mention names.

Now , let's apply some of this thinking to private "impulses". My contention is that there was indeed a credit boom in the 80's , that households eagerly participated ( as did all major economic sectors ) , and that interest costs did not prevent that credit boom from generating significant economic activity. First , let's see if Mason's "primary surplus" calculations really matter for purposes of determining whether credit stimulated demand . Here's a graph of two looks at annual change in HH debt as a share of DPI , in which I've created an artificial version of Mason's figure 7 , by adding a 7.5% debt share to the red , upper line , and by flipping the axis ( so as to more closely match Mason's ) by imposing a negative sign :

http://research.stlouisfed.org/fred2/graph/?g=yWx

As you can see , the red line households are in "primary surplus" post-1980 except for a brief spell ~1985 and then from ~2000 until the crisis. This matches Mason's graph enough for us to test the concept of fiscal impulse , using a " primary surplus " or interest-adjusted HH sector compared to an un-adjusted control.

The credit impulse is a direct analog of a fiscal impulse , and is calculated the same way. With the fiscal impulse you take the difference between annual deficits as a share of gdp , from year one to year two. With the credit impulse , you first must get the "deficit" by taking the y-o-y change in the debt stock as a share of gdp , then you take the y-o-y difference again , as for the fiscal impulse. For this graph I'm using debt as a share of DPI instead of GDP so as to match Mason's work , but using GDP will give similar results. I'm going to include a measure of real gdp growth in the graph , as well ( green line , right scale , yoy % growth ) , so we can see what the relationship between credit impulse and growth looks like. I picked the sum of PCE plus residential investment as a GDP proxy that would be associated with HH spending :

http://research.stlouisfed.org/fred2/graph/?g=yWH

Why aren't there two credit impulse lines ? Shouldn't we see some difference between the interest-adjusted , primary surplus HH and the non-adjusted one ? No , we shouldn't. Both lines are on the graph , they're on top of each other. The credit impulses are identical.

Because I had flipped the axis , the movement of the impulse line becomes stimulatory as it starts to move south from positive positions on the graph , and contractionary as it moves north from below ( which is the opposite of the way you'd see it in most credit impulse graphs ) .

Please note the tight linkage of the credit impulse movement with changes in growth rate of the gdp proxy - when the impulse line turns down ( stimulus ) , the gdp proxy goes up , and vice-versa.

Also note that the Great Moderation growth of the gdp proxy was very steady from the end of the 1990 recession until the crisis , and this was associated with the impulse measure spending very little time in the contractionary zone ( i.e. above the zero line ).

"As for your latest attempt at FRED, you are dividing the change of a nominal quantity by a level nominal quantity in all four lines. This is almost 100% guaranteed to show a rise through 1980, and then a fall since, for the simple reason that inflation peaked in 1980."

Why can't you get movements in your PCE/DPI measure to match the PCE/GDP measure ?

Where'd the trillion bucks go ?

What the hell are you talking about ? There's no rule against dividing a change in a nominal quantity by a nominal quantity. You know , like changes in debt as a share of gdp , changes in a money stock as a share of gdp.....

We can see that the HH credit impulse correlates very well with household-associated real growth throut the range accessible in FRED. We also know that the Reagan recovery years are often looked back on with fond memories because of the relatively vigorous real gdp growth of the period. What people don't get told is that it was due to a tremendous , and irresponsible , credit boom , that left us with higher economy-wide leverage and a failed S&L banking system - one that got ~1000 S&L execs some jail time ( that part I'm pretty fond of myself ).

How does it qualify as a "credit boom" ? Well , going back to 1955 , there is exactly one period where the credit market debt of all sectors- business , household , gov't , and financial - grew at a rate well above 10% for a significant period. You can see this for yourself in the latest Z1 in table D1 ( % growth ) , which covers back to 1982 , I think. You can also plot the sectors on FRED all the way back to the 50s.

There were a couple others big credit events , of course. The 2000s we remember well , but we also had a pretty good one in the mid-late 70s , no doubt as a result of all the new financial deregulation. The 50's were credit-driven too , but keep in mind , when the debt stock is at 50% of gdp and grows at 10% , it's only growing at 5% as a share of gdp. In the 80's and 2000s we were at much higher debt/gdp levels ( ~150-250% ), so more absolute debt growth was needed to get the same boost when measured as a share of gdp.

Here's a graph showing the growth of domestic nonfinancial sector debt as a share of gdp in % ( left scale , blue line ) , as well as the same debt stock shown as debt as a % of gdp , to show the leverage progression over time ( right scale , red line ) :

http://research.stlouisfed.org/fred2/graph/?g=yXp

If you zoom in on the time frames , you can see that the mid-80s and the mid-2000s -, uniquely - each had 4-year periods where the debt stock grew at 15-20% per year as a share of gdp.

You'll also notice that those are credit booms where leverage ran away to higher levels. The rest of the time , back to the mid-50s at least ,we had stable levels of debt/gdp.

If you zoom on the last 5 years or so , you'll see that deleveraging was a brief and limp affair , amounting to only a few points off the economy-wide debt/gdp level , and over and done with by 2011. I've included the TCMDO data link in the series 2 box , so you can plug it in to look at total leverage including the financial sector. Again , the deleveraging by this measure appears to be about done. Who knows , maybe the next Z1 will bring good news on this front. I think we're still way over-levered on an economy-wide basis.

So , yes , the 80's Reagan miracle was a debt-fueled magic trick. You can't look at this data and call it otherwise. And though I don't deny the adverse impacts of Fisher effects and such , and think that probably helps explain why so much 80's debt had to be pushed out the door to get the desired growth , the idea that a "primary surplus" - among the HH or amy other sectors - caused the added debt to be neutralized , is simply hogwash. Throw enough new debt at an economy - no matter how insolvent it might be - and you'll get a stimulus. That doesn't mean we should do that now - we've been a Ponzi economy for far too long already.

"You do know that "headline" and "primary" refer to different measues than "CAPB" , don't you ? Let's assume not , and review again from the link you so generously provided. I'll bracket some of the more important stuff , > < , thusly , as I know you tend to drift off at times....Got it now ? For measuring overall stimulus , use overall measures , like "headline" ( aka , gross , nominal , etc ) , or "primary" ( headline minus interest ). Leaving automatic stabilizers aside , as in cyclically-adjusted measures , is not a good idea."

Immediately after I posted that link at April 24, 2014 at 9:31 PM did I not say the following?

"Cyclically adjusted measures of the household primary balance don't exist. In fact I'm not sure it would be wise or even possible to cyclically adjust the household sector primary balance."

The whole point of posting that link was *not* whether changes in the primary balance should be cyclically adjusted (which I had thought was completely irrelevant in this context) but that it is near universally accepted that at a bare minimum the best way to measure fiscal stimulus is by *changes in the primary balance*.

"Why can't you get movements in your PCE/DPI measure to match the PCE/GDP measure ?"

I really have no idea what you are talking about.

"Where'd the trillion bucks go ?"

If I understand you correctly it was never there in the first place. The BEA adds imputed rental income to personal income and imputed rent to personal consumption even though homeowners don't actually pay themselves any rent. (The BEA also neglects to subtract property taxes from disposable personal income.) This is of course totally inconsistent with the general BEA convention of not including non-market transactions.

"What the hell are you talking about ? There's no rule against dividing a change in a nominal quantity by a nominal quantity. You know , like changes in debt as a share of gdp , changes in a money stock as a share of gdp....."

It's still not clear to me what you were trying to show by that exercise, so without a context I think it does matter.

I don't think the missing money is important - the exercise was simply to show that when you start getting deep into the hypothetical weeds , cherry-picking what to include and exclude , it's clear to me that you're just driving to a desired result.

Mason entertains a pretty fantastic hypothetical himself in his paper. He suggests that if income growth , inflation and interest rates had all stayed the same as in 1945-1980 , we'd be fat and happy now , with low leverage. Yet when I posed my own hypothetical to him on his blog , he waved it off. I asked what would have happened to growth without the increased leverage - what if we'd stayed at the ~130% nonfinancial debt/gdp of the pre-1980 era ? That would be ~ 20 trillion in debt that wouldn't have happened , based on conditions today. What would that have done to gdp and asset price growth ?

I worked up a little more realistic model of the "positive primary balance" household. I used a 30-year Treasury rate applied to the entirety of household debt , and subtracted that amount from the annual new hh debt . This does an even better job in matching Mason's graph , since it shows the negative balance spikes in the 70's , as well as around 1985 and post-2000. Unfortunately the data series I used only goes from '71 - 2004. Here's the annual debt as a share of GDP profiles:

http://research.stlouisfed.org/fred2/graph/?g=yYH

I'm sure it's not totally realistic , since there's a big mix of debts and interest rates that would apply in the real world , but at least it captures the big move up in long rates. The thing to note is that though you generate a big difference between the two measures of annual effective new debt , you don't change the profile much , thus the credit impulse pattern doesn't change much ( though it changes a lot more than in my first stab at this ):

"What people don't get told is that it was due to a tremendous , and irresponsible , credit boom , that left us with higher economy-wide leverage and a failed S&L banking system - one that got ~1000 S&L execs some jail time ( that part I'm pretty fond of myself )."

Here's the very same "credit impulse" graph you posted but set to annual frequency:

https://research.stlouisfed.org/fred2/graph/?graph_id=174887

Note that from 1979 through 1992, a period of 14 years. the only years where the acceleration of credit is "positive" are 1984 and 1985. This is exactly the same as what I showed you using changes in the primary balance. There simply was no credit boom in the 1980s.

"Well , going back to 1955 , there is exactly one period where the credit market debt of all sectors- business , household , gov't , and financial - grew at a rate well above 10% for a significant period."

But almost all of the 1980s growth in debt was due to the huge increase in the real effective interest rate. This is true not only of the household sector but also of the other three sectors as well. In fact the nonfinancial sector and financial sectors consistently ran primary surpluses during the 1980s. And the primary deficit of the government sector was only 0.6% of GDP on average which is exactly the same as it averaged in the 1970s.

Fisher dynamics explain almost the entire increase in leverage in the 1980s.

"If you zoom in on the time frames , you can see that the mid-80s and the mid-2000s -, uniquely - each had 4-year periods where the debt stock grew at 15-20% per year as a share of gdp."

The crucial difference is that in the mid-2000s the household and financial sectors were running primary deficits whereas in the 1980s they were not. The only reason why leverage soared in the 1980s was high real effective interest rates.

Excellent blogging.The Fed's squeamish aversion to a larger balance sheet is puzzling, and not rational. I assume it is some sort of cultural bias. Another puzzler is the strange accounting that is law pertaining to Fed LSAPs. Under law, they must extinguish the process of bond principle repayments.

So the Fed prints cash and buys the bonds. Bond holders have been paid.

But when the bonds mature and are paid off by the Treasury, then proceeds are extinguished. (Interest payments, for whatever reasons, are passed back to the Treasury and are a nice little filip for taxpayers).

The Fed must the keep buying bonds to maintain its portfolio and the stimulative effect of QE.

Seems to me the Fed should be able to buy Treasuries,pay down the national debt, and then receive principle repayments and funnel those back to the Treasury. Some sort of archaic accounting standard are preventing good monetary policy.

David,Causality, as I understand it, runs from QE to portfolio rebalancing to asset prices to wealth effects and higher spending. This brings up three questions about broad, lasting and observable market trends:

Why did U.S. asset prices boom for five years if agents perceived that the increase in the base was temporary?

Why did European asset prices boom during that time if agents perceived that the ECB was way too tight?

Why hasn't a two-year boom in Japanese asset prices produced a self-sustaining spending recovery? (clearly, the economy there is cooling)

I realize the links between expectations and spending are complex, and things like fiscal contractions get in the way. However, I think that Market Monetarism sweeps away this complexity by targeting market expectations and not actual spending. It seems to me Fed policy gave Market Monetarists exactly what they wanted in terms of asset price effects. How is it to blame for lackluster nominal spending?

Sadowski,"Why did European asset prices boom during that time if agents perceived that the ECB was way too tight?"

Not sure where I mention ECB QE in that statement.

If the STOXX Europe index hasn't boomed, that is news for the unfortunate bears (me included!).

Seriously though, I think Market Monetarism can't decide whether asset price levels or changes matter. The portfolio balance and wealth effects, arguably, have everything to do with LSAP levels ("stock") that produced asset price and wealth effect changes ("flow"). For purposes of producing a strong recovery, it is the delta on asset price that matters, as this produces a delta in wealth. Otherwise, FDR could be said to have had no effect on spending: after all, the Dow did not regain the 1929 peak until 1955! By the measure you use to define "boom", the gold standard exit was a dismal failure in juicing asset prices...

Sadowski,Fine, let's focus on the U.S. Asset prices tripled, as in the 30's. Clearly, this is a massive recovery in expectations of nominal spending. Market Monetarism holds those expectations as central to the performance of the actual economy. In other words, expectations are self-fulfilling. To fault the Fed is to say that, somehow, they failed to produce a strong recovery in spending expectations. This implies that market prices are not a good measure of those expectations. Which leads us back to the basic premise: that the Fed should target market prices.

One could, I suppose, make the claim that the equity, high yield, commodity and commercial real estate markets do not reflect nominal spending expectations per se. This argument would claim that an NGDP futures market would have performed very differently to the domestic-focused Russell 2000, to give just one example. This seems to me to be an interesting line of thought as it points to potential failures in both market efficiency and/or wealth-effect transmission channels (such as Tobin's Q). Why did these failures occur, and are there structural solutions go beyond monetary policy? It seems to me that these questions are the ones logically implied by Market Monetarist thinking.

"This implies that market prices are not a good measure of those expectations."

This statement assumes that market prices are irrationally high. But I don't think that is the case.

"This argument would claim that an NGDP futures market would have performed very differently to the domestic-focused Russell 2000, to give just one example."

Since 2007Q2 NGDP is up by 18% and the Russell 2000 is up by 36% . But is the Russell 2000 really representative of the entire economy? I think not. It's a small cap index.

Since mid-2007 the Russell 3000 is up by 24%, the S&P 500 is up by 21% and the Dow Jones is up by 17%. One could spend an eternity discussing what is the exact fair market value of the stock market, but I don't see how anyone can rationally say US equities are unusually overvalued right now.

"This seems to me to be an interesting line of thought as it points to potential failures in both market efficiency and/or wealth-effect transmission channels (such as Tobin's Q)."

Here is Tobin Q and investment for the nonfinancial corporate sector since 1993Q1:

The correlation is significant at the 1% level with Tobin Q explaining over 56.9% of the variation in investment. Note that Tobin Q appears to lead investment as well. Thus it should not be at all surprising that Tobin Q Granger causes private nonresidential investment (PNFI) at the 1% significance level and that the impulse response is significantly positive.

So it seems to me that the monetary transmission mechanism channels are are working extremely well. All we really need is for the Fed to target an even higher level of NGDP.

Apparently a “permanent increase in the monetary base” will mean a “permanently higher price level and nominal income in the future. Such knowledge would cause current investors to rebalance their portfolios away from highly liquid, low-yielding assets towards less liquid, higher yielding assets.” (All quotes are from David's post, BTW.)

Now wait a moment. Just to keep it simple, if the percentage expansion in the base exactly equals the percentage rise in the “price level” and “nominal income”, then NOTHING REAL HAS CHANGED. All that has happened is that the value of money has fallen. There is therefore no reason to expect more “investment spending” in REAL TERMS, or “a robust recovery in aggregate demand.”

David, Marcus Nunes put up a chart showing that at least in some quarters expectations have been consistently saying that short term interest would rise. This happened repeatedly over the last few years. So if the missing ingredient was expectations, who's expectations are we talking about exactly? Somebody more significant than what this chart reflects I guess?

Some Other Writings

About Me

I am an assistant professor of economics at Western Kentucky University in Bowling Green, Kentucky. I am using this blog as an outlet to express my ideas, concerns, and questions on macroeconomics and markets.